What are pre-tax deductions, and why do they matter?

a photo of two payroll folders, one labeled over time and the other labeled reg time

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Payroll deductions are amounts of money withheld from employees’ pay checks. These amounts are used for a variety of things, such as the provision of health care and paying taxes. They can be mandatory or voluntary, and how much is withheld depends on the worker’s total earnings and status. Some amounts can be taken out on a pre-tax basis, while others must be taken out after other payroll taxes. However, pre-tax deductions are usually better for workers. Keep reading to learn why.

How Payroll Deductions Work

In most cases, companies process payroll deductions every pay period, whether weekly, every two weeks, or monthly. These deductions are based on various tax laws, as well as withholding details that have been given to an employer by court order or by the employee. Almost all businesses choose to automate this process in order to reduce the number of mistakes made and to make sure that payments are filed on time.

Employers withhold money based on a number of factors, which extend to benefit selections as well as to state and worker withholding certificates. Since some states, such as Texas, do not require workers to pay income tax, the place that you live and work also dictates how much you do or do not pay.

What Are Pre-Tax Deductions?

A pre-tax deduction involves taking money out of a worker’s gross pay before taxes are withheld from the pay check. The main benefit is that this money is wholly excluded from gross income. This means that the worker’s total amount of taxable income is also reduced. For small businesses, taking money out before the pay check is taxed means paying less in overall payroll taxes. That can be a good thing.

Pre-tax deductions can also reduce insurance dues for state unemployment and the federal unemployment tax. Workers also save with FICA taxes, which extend to Medicare tax and Social Security tax. Since the taxable income is reduced in these cases, workers pay less toward these types of taxes. Overall, there are many pre-tax deductions that can apply to a person’s pay check, such as for health plans, life insurance, etc. These plans are often thought to be of benefit to the workers who choose to take part in them. Employees can save a lot of money this way.

Keep in mind that there is a limit to the amount of savings that a worker can earn from pre-tax deductions. For instance, the IRS restricts the amount of money that can be directly added to a 401(k) account every year. For 2020, the limit was right around $19,500. 

What Are Post-Tax Deductions?

Post-tax deductions are the opposite of pre-tax in that they are taken from a worker’s earnings after all other taxes have been withheld. Thus, they reduce net pay as opposed to gross pay, which means that their tax burden will remain the same. Some of the more common types include:

  • Disability insurance
  • Charity donations
  • Union dues
  • Roth IRA retirement accounts

In many cases, workers must decide if they are going to use post-tax deductions. However, this isn’t the case with wage garnishments. These occur when regulatory agencies, the IRS, or the courts order that a portion of post-tax earnings be withheld. Such as when the worker fails to pay alimony or child support on time, for example.

The kinds of income that can be garnished include bonuses, salaries, hourly wages, and more. Companies that do not withhold all of the required payments may be liable for making the payments themselves. This is why it’s important for businesses to keep good payroll records and to process payroll on time.

Voluntary Payroll Deductions

These types of payroll deductions are mainly used to cover the costs of optional benefits. Employees must tell their employer of their desire for voluntary deductions with written consent, usually by signing a form that has all of the benefit details spelled out. Once this has been placed in writing, the employer can withhold earnings for things like insurance premiums and similar payments. 

Types of voluntary payroll deductions include:

  • Retirement plans – These include Roth IRA accounts and 401(k) accounts. While 401(k) accounts are often paid into pre-tax, Roth IRA accounts are always post-tax.
  • Health insurance plans – Many companies offer health, vision, and dental insurance plans that include premiums that are paid pre-tax.
  • Certain types of job expenses –  Some job related expenses may be deducted from a worker’s earnings, such as travel, meals, and union expenses. Certain states directly prohibit these, however.
  • Group term life insurance – Many employers offer standard term life insurance for free up to $50,000 in total coverage. Workers who want to add some supplemental life insurance must pay for it post-tax.

Pre-tax Deductions: Takeaway Points

Pre-tax deductions reduce a worker’s taxable income. While workers can benefit from both pre-tax and post-tax deductions, the former are thought by many to be better because they save more money. Either way, it is important for businesses to keep accurate payroll records and to deduct the right amounts from workers’ pay checks. To make it easy, TimeForge offers many payroll integrations to help you keep your payroll, HR, and employee attendance data in sync. Save time, keep accurate records, and avoid costly fees by entering details in just one platform instead of two.

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